Investment Climate October 2016

The stock market recovered nicely in the third quarter after the “panic” over the Brexit vote subsided and the focus turned to the slow but consistent growth in the economy that has prevailed for a number of years now.  Markets in general, as well as our Core Growth Strategy, ended the third quarter with a year-to-date return in the mid-single digits.  

While some would marvel over the market’s move upward since the 2008-9 debacle, we believe that viewing market performance with a start date of March 9, 2009 (the day the market bottomed in the wake of the crisis) is a big mistake.  While we are pleased, and frankly, not surprised that the market has recovered from the depths of its decline in 2009, we are dismayed at the significantly below- average growth in the economy, and in the price of the average stock over the course of the last 15+ years.  Although during that period we have witnessed outperformance in our Core Growth Strategy versus the market in general, we have not seen the kind of growth we would have expected considering the massive technological advancements that have benefitted the world over that same period of time.

We will begin by emphasizing that we are more confident than ever that the types of companies we focus on in our strategy are poised for significant success which we believe will be reflected in their stock prices in the years to come.  But why has it been such a slow slog forward?  

Simply put, the “investment climate” of the last 15 years has not been ideal, and particularly it has not been well-suited towards entrepreneurial activity and capital investment.  The reasons for this are plentiful, and have been discussed before, but to recap what we believe to be the primary culprits: government intrusion into the affairs of free enterprises has been, at best, meddlesome and, at worst, stultifying.  With all good intentions, and in the wake of scandals like Enron and Worldcom in the late 1990s, and the mortgage/housing/ financial crisis in 2008-9, the politicians “acted” by giving us regulatory regimes like Sarbannes-Oxley and Dodd-Frank (with its offspring, the Consumer Finance Protection Board) that has made it increasingly difficult for businesses (especially smaller ones) to navigate the already complex web of regulations.  If there is need of evidence of this problem, to us -- professional investors who seek out growing businesses for a living -- one need look no further than the dearth of initial public offerings (IPOs) of common stock in the last 15 years.

This drought has become an epidemic, in our view.  While there have been fits and starts in the IPO market over the last few years, the general trend has been abysmal for so long that it has considerably limited our ability to find new growing companies in the public markets.  This is, in our view, the single most important issue facing the investor today!

Fortunately, we believe we have such a formidable group of opportunities in our strategies for growth investing in both public and private companies that we don’t fear this situation, yet.  As previously mentioned, we have never been more confident in the positions we have taken in both public and private holdings.  However, it does concern us for the future, and particularly future generations of investors, that this drought in new business formation has run for so long.  As we have said for years, echoing our mentor Richard C. Taylor: “we get by in spite”.  When Dick spoke those words he meant to describe the errors of the ways of those who have over-intruded into the private affairs of businesses, just as we have witnessed in the last 15 years.  

While we acknowledge the challenges that such intrusions place on businesses, we are optimistic that the remarkable business men and women who run the companies we own will shine regardless of what unintended hurdles are foisted upon them.  Doug Waggoner from Echo Global Logistics, Eyal Waldman from Mellanox Technologies, Colin Reed from Ryman Hospitality Properties, Arkadiy Dobkin from EPAM Systems, Anat Cohen-Dayag from Compugen, Jules Urbach and Alissa Grainger from OTOY, just to name a few, are examples of the brilliant and committed stewards of our companies who, with their entrepreneurial spirit and innovative products and services, are impacting our world.  Fortunately, we can benefit as we standby and watch them do their work!

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Passive Investment and Marxism!

We were very pleased to see someone else pointing out the potential negative societal aspects of passive investment, even going so far as to compare the phenomenon to something worse than Marxism!

This Bloomberg article highlighting commentary from investment firm Sanford C. Bernstein Co., LLC, hits the nail on the head.

Hooray! we say.  We just wish more financial industry folks would speak up on the subject.

We've been writing about it for a long time:

December 2015: "Get Out of the Market"

Stay tuned as we will keep on the topic!
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"Boring Markets"...Really?

We came in to work this morning and the first thing we looked at was a daily market commentary from a major Wall Street firm whose first words were "Market Update - another boring and quiet day in US equities...."  Mind you, we are in no way trashing this Wall Street firm, although they will remain unnamed (they, and anyone who reads their work know who they are).  We would add that this is one of the few Wall Street firms we respect for doing some very good research on publicly trading companies.  But the comment just underscores an underlying problem in the way the world views the role of the market.

We are fully prepared to accept that we just may be ornery as we enter our sixth decade of managing money professionally for ourselves and our clients, but it occurs to us that the mentality that views the market as "boring and quiet" has grown to put too much emphasis on the "market" than is healthy.

Clearly, we are picking on this one commentary, and we admit that it's not fair to that firm, for they are by no means alone.  We would posit that most of the "investment firms" (we use that term skeptically) on the street, are anything but and have become gigantic trading houses, or as some may better describe them, giant gambling casinos!

Our patriarch and mentor, Richard C. Taylor used to reference the concept that one could put capital at risk in three possible ways: by gambling (relying on pure chance), speculating (relying on an educated guess), and investing (relying on thorough research and business-related knowledge over long periods of time).  He was certainly not the first one to put these three terms together in an effort to differentiate them, but it was definitely at the heart of his investment process and we carry on that idea today as we deploy capital.

The problem, in our assessment, is that far too much of the focus with respect to capital deployment is dedicated to the first two types of risk.  In fact, we would argue that much of what is considered "investment" nowadays is, at best, speculation and more likely simply gambling.  We believe this is having negative ramifications for true investment, as we define it above.

Why is this important?  Because the economy depends on capital investment.  Without it, the system we adhere to, entrepreneurial capitalism, simply is not allowed to operate at full potential.  As the investment world moves towards schemes that are more aligned with speculation, and even gambling, it loses perspective on investment and thus distorts the allocation of capital, creating dislocation that affects the economy, and ultimately all of us.

Perhaps an example will best illustrate the predicament.  Our good friend and venture capital partner, George Gilder, in his recent book, The Scandal of Money: Why Wall Street Recovers But The Economy Never Does, points out that each day over $5.3 trillion dollars (with a T) trade in the world foreign currency markets.  This is astounding!  This is capital that is essentially trading on a guess (at best) and can most appropriately be categorized as gambling.  We have long said we have no problem with traders.  They are very necessary to provide liquidity to the market.  But this is an example of the tail wagging the dog!  We can assure you that not even close to $5.3 trillion dollars is being invested in innovative, entrepreneurial companies in a year.

In  February 2009, our Chief Investment Officer, Gerry Frigon, gave a speech before a business symposium on the Central Coast of California.  This was in the midst of the mayhem caused by the mortgage and credit crisis.  In it, he described the need to get back to investment for investment's sake.  In other words, stop trying to game the system, and look at businesses as the investment, not the "market".  

Some people may think that investing in innovation that may take a few years to really make a difference is "boring," but we don't think so at all -- and we believe it is much more beneficial and necessary for economies, and ultimately much more beneficial for investors (as opposed to "gambling," which may be exciting but is often quite bad for investors). 

It would appear that we still need to be giving that speech.
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Investment Climate: The Importance of Brexit

What a crazy few weeks in world markets!  The second quarter was shaping up to be a decent rebound from the sloppy start in January,  but the markets made an abrupt about-face and sold off dramatically in the wake of the vote in Great Britain to leave the European Union. The “Brexit” vote was a surprise to most speculators/traders who had taken the consensus bet that it would never actually prevail.  The consternation and teeth gnashing emanating from the “elites” in both Europe and the U.S. was so pervasive and fierce you would think the world as we know it was truly ending!  In our view, it was another case of “here we go again.”  

How many more tales of impending doom, which simply don’t come about, do we need to hear before the sober world of investors takes hold?  Somewhat surprisingly, the market may finally be tiring of these pundits of pessimism since, as of this writing, barely three weeks after the June 23rd Brexit vote, the stock market averages have powered to new highs, ignoring the sirens of the elite class.  

On the day of the Brexit vote results, we posted on our blog (entitled “Don’t Fear Brexit”) that we believed the vote was a significant positive step toward rebuking the decades-long degradation of Western Europe at the hands of “democratic Socialism.”  A system that has resulted in perpetual sub-par growth throughout the European continent.  

It was our stated belief in 1989, when the talk of a “United States of Europe” was taking hold and the stage was being set for the European Union’s formation, that it would be extraordinarily difficult to achieve monetary and economic union without political union.  Essentially, without a U.S.-style constitution the project was destined to have major problems.  While we certainly argued for the benefits of a common currency amongst nations so closely tied geographically and economically, it was that stubborn political and even cultural difference amongst these same countries that we thought would be at least problematic and potentially fatal to the union.  If those political issues were not eventually dealt with (sooner rather than later) at some point a break would ensue.  The beginnings of that break appear to be underway.  

The lack of a truly “democratic” political structure, and, in fact, what turned into the equivalent of “taxation without representation” via the bureaucratic, unelected European Parliament in Brussels finally reached a breaking point as the British people decided they were tiring of having mandates forced upon them by people they had no say in putting into power.  Worse, these same bureaucrats advocated a level of socialistic control over the Europe that has resulted in the weak economic growth, to which we previously described, and a series of financial train wrecks such as the Greece mess, which we have discussed at length in past commentaries.

To reiterate, it is our view that the events in Europe are a very positive step in beginning the healing process from decades of mismanagement in Europe.  However, we would strongly emphasize that this in no way means that we are taking an “anti-globalist” view in our positive reaction to these events.  It does not mean we favor trade protectionism in any form.  We thoroughly endorse the free flow of trade amongst nations and would agree that a positive byproduct of the European Union has been the role it has played in keeping peace on the European continent for the longest time in world history.  So it is imperative that one not misread our support of Brexit and a retooling of the order in Europe as support for those forces that would throw up tariffs and other protectionist obstacles in the way of economic progress, or use misplaced nationalism to allow for the rise of bad actors the likes of which caused two world wars in Europe. 

However, as was our view in 1989, a U.S. of Europe, along with a constitution and bill of rights, is not going to happen across the European continent any time soon.  Probably never.  That being the case, in order for truly free enterprise to flourish, it is crucial that those forces propagating the exercise of freedom, in all forms, be allowed to flourish.  If those forces emanate from places like a sovereign Great Britain, a country with a recent history of promoting free enterprise, then that is a step in the right direction.  Perhaps it is enough to stem the tide and swing the pendulum back towards policies that are less intrusive on businesses and citizens alike, and promote economic growth through low taxes and easy access to capital markets across the globe.  Maybe it will encourage a similar movement in the U.S of America, which is growing like Europe of the last five decades (weakly) under the weight of ever more regulation and taxation; a topic we have harped on in these commentaries for years.  For while great companies can still succeed in spite of these intrusions, they would flourish all the more in an environment more favorable to business formation.
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Don't Fear Brexit

In 1989, as we were hearing about the benefits of the "United States of Europe", we can clearly recall our skepticism over the noble idea of creating a common currency throughout Europe without a clear political union to go along with it.  Was it reasonable in an area so geographically tied together to have a common currency to allow business to transact their trade across the many borders in a more effective way?  Absolutely!  Yet it seemed impossible to us to think that the myriad cultural differences throughout that same geographic region would allow for that necessary political cohesiveness.  Essentially, our thoughts were that without a U.S.-style constitution, it seemed improbable, at best, that the experiment would succeed.

Yesterday, voters in the United Kingdom dealt a devastating blow to the experiment of a "United States of Europe" with their vote to leave the European Union.  The "elite" of Europe, and throughout the world, including America, warned of cataclysmic ramifications if the vote to leave were to win.  We believed all along that was ridiculous and continue to believe so in the wake of the approval by the British people to leave the Union.  Not only do we think that it is ridiculous to think that Brexit would be cataclysmic, we believe the historic vote is a step in the right direction towards exposing the failure of socialism in Europe and throughout the world!

Whatever negative reaction happens in the markets today or over the course of coming weeks and month, related to fear over this movement, we believe it will be short-lived.  We stand ready to take advantage of any weaknesses to add to our holdings in great, innovative companies run by the solid entrepreneuers who make our capitalist system so vibrant.

Stay tuned for more updates on this amazing turn of events.
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